Habit Persistence and Zero Lower Bound Risk under Optimal Discretionary Monetary Policy

Abstract

Previous studies have shown that the risk of nominal interest rates hitting the zero lower bound (ZLB) has profound implications for monetary policy. In this paper, we show that habit persistence is a non-negligible deep parameter under optimal discretionary policy when the risk of the ZLB is taken into account. The uncertainty effect, which is defined as differences between risky steady states (RSS) and deterministic steady states (DSS), increases as habit persistence increases. Under empirically reasonable values of habit persistence, we show that the RSS of the nominal interest rate would reach the ZLB under optimal discretionary policy. Moreover, the uncertainty effect of the ZLB worsens welfare more as habit persistence increases.

Keywords: Liquidity trap, Zero lower bound, Habit persistence, Internal habits, Risky steady state, Uncertainty effect, Optimal monetary policy

JEL Classification: E31, E52, E58